Why Financial Appearances Might Matter: An Explanation for 'Dirty Pooling' and Other Types of Financial Cosmetics

47 Pages Posted: 10 Mar 2003  

Claire A. Hill

University of Minnesota Law School

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Abstract

Companies openly and notoriously use accounting techniques (financial "cosmetics") to improve their financial appearance. They have been doing so for a very long time. Common examples include the use of "pooling" accounting in mergers, and the use of long-term leases that are functionally debt. The former increases earnings; the latter reduces debt. Both higher earnings and lower debt make for a more pleasing financial appearance. Companies' open and notorious use of financial cosmetics presents a puzzle. Financial vanity should be punished; expenditures on cosmetics applications divert from more worthwhile (that is, more profitable) pursuits. Yet the practice persists. I propose an explanation. Companies fear that markets, attracted by beautified companies' luster, might shun plainer ones. This fear is rational: Proclamations that financial appearances matter are loud and constant. So long as the cosmetics are tastefully applied (that is, the techniques do not adversely affect cash flows), markets seem indifferent; in short, there's nothing to drown out the proclamations. Why not? I argue that markets, trying to minimize aggregate information costs of unmasking beautification, concentrate their resources on discouraging and detecting makeup that masks a company's true appearance. They are indifferent to, and may even prefer, open and notorious makeup applications. The more openly a company applies its makeup, the more markets know about how the company really looks underneath. And a company applying its makeup in public may be signalling that it has little to hide.

Keywords: accounting, dirty pooling , financial appearance, financial cosmetics

JEL Classification: G38, K22, M41

Suggested Citation

Hill, Claire A., Why Financial Appearances Might Matter: An Explanation for 'Dirty Pooling' and Other Types of Financial Cosmetics. Delaware Journal of Coporate Law, Vol. 22, No. 1, 1997. Available at SSRN: https://ssrn.com/abstract=333025

Claire Ariane Hill (Contact Author)

University of Minnesota Law School ( email )

229 19th Avenue South
Minneapolis, MN 55455
United States
612-624-6521 (Phone)

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